Three myths that sustain the global economic crisis

The temporary, technical problems created when banks stopped lending to each other in August 2007 are still with us and the myth that there was nothing wrong with the economy before then has to be exploded before there can be progress

By Larry Elliott / The Guardian

Illustration: Mountain People

In the UK, the summer of 2007 was a run-of-the-mill affair. Former British prime minister Tony Blair had stepped down in late June and his successor, former British prime minister Gordon Brown, was enjoying a honeymoon period. It was a year without a soccer World Cup or an Olympics, while Roger Federer won the men’s singles at Wimbledon and English cricket involved series against the West Indies and India.

Then, on Aug. 9, came reports that central banks had been active in the markets. The Guardian said the action involved pumping billions of British pounds into the financial system to calm nerves amid fears of a credit crunch. The trigger for the panic was the decision by BNP Paribas to block withdrawals from three hedge funds because of what it called a complete evaporation of liquidity. A spokesman for the bank described the move as a technical issue and said he hoped it would be temporary.

Technical? Temporary? Within six weeks, it became clear the meltdown of August 2007 was no short-term blip when investors queued outside branches of Northern Rock for three days in the first run on a leading UK bank since the mid-19th century. Five years later, the global economy has yet to recover from the deep trauma caused by the hubris of the bankers.

Back then, though, there were few who imagined that Aug. 9, 2007, would prove to be such a milestone in financial history. The Guardian carried the story on page 29, because there seemed to be no reason to believe this was any different from previous bouts of jitters in the markets. It took a few days to work out what the bankers had been up to, because the “masters of the universe” had their own esoteric language the rest of us were not supposed to understand. Talk of mortgage-backed securities, credit default swaps and over-the-counter derivatives was the equivalent of 12th century monks writing Bibles in medieval Latin for peasants who only spoke English.

Stripped of the jargon, it is now quite easy to see what happened. Banks were taking large gambles with precious little capital in reserve if the bets went wrong. Individuals were borrowing at levels only sustainable if the value of their share portfolios and homes continued to rise year after year. Governments assumed that booming tax receipts were permanent and increased public spending.

In August 2007, the air started to escape from this gigantic bubble. It happened in three stages: The financial sector was the first to feel the impact, because while it was evident that almost every bank had been up to its eyeballs in investments linked to the US housing market, nobody knew for sure just how much money each institution stood to lose. The financial system grinds to a halt if banks refuse to lend to each other, as they did in August 2007.

It took more than a year for the second stage of the crisis to unfold. During that period there were a number of developments: The crisis in finance deepened, house and share prices fell, and inflationary pressures increased as a result of a sharp jump in the cost of fuel. When Lehman Brothers went bankrupt in September 2008, the global economy was ready to blow and the next six months saw the biggest slump in output since the Great Depression.

Governments arrested the slide into a 1930s-style slump by concerted and coordinated action, but wrecked their own finances in the process. Bailing out the banks was expensive, particularly since much lower levels of output reduced tax revenues. Banks felt they had too much debt. Consumers felt they had too much debt. By mid-2009, most governments also felt they had too much debt. It was not a comfortable place to be.